Tuesday, February 10, 2009

Government leaders will need to take a "shock-and-awe" approach towards the economy as indicators show a worsening recession, Mohamed El-Erian, co-CEO of the Pimco bond fund, said Friday. Asked what he would do if he stood in Treasury Secretary Timothy Geithner's shoes, El-Erian said the government needs to take drastic, immediate and comprehensive action to combat the threats posed by the crumbling economy.

Do people like El-Erian actually think before speaking? Do they think at all? Perhaps not thinking is a luxury that only the very rich can afford?

A leading bond fund manager is asked for his views on how U.S. government policy might be designed to combat what appears to be a worsening recession. How will he answer? One might hope that the experienced sage will draw on the lessons learned from past interventions in the U.S. and elsewhere. Nope. Perhaps he will draw on a few philosophical principles concerning the role of government in the economy. Nope. Perhaps he will frame his views in the context of a coherent economic theory. Yeah, right.

Nosiree...forget all that BS. Instead, for inspiration and as a model of successful intervention, our high-paid fund manager draws on one of the greatest U.S. policy failures of all time -- the "shock and awe" bombing campaign that preceeded the U.S. invasion of Iraq. How's that as an example of "drastic, immediate, and comprehensive" action? And oh boy, that sure turned out well, didn't it?

Thursday, February 5, 2009

Another slow day. But trust General Electric's Chief Executive, Jeff Immelt, to provide us with some entertainment value (as opposed his real job of generating shareholder value). Check out the story here. Here is a quote:

The U.S. economy is in its worst shape since the deep recession of 1974 and 1975, and if it deteriorates further the most meaningful comparisons will be to the Great Depression. We're at least to 1974-75. Once you break through '74-'75, you don't stop 'til you get to 1929. Unlike the other downturns that I've been a part of, this one is faced with limited liquidity. If liquidity exists, it's not coming back readily. That's why the government's role in this cycle is so gosh-darned important.

Jeepers...I had no idea. But gosh-doodly, I suppose this is why he is paid the big bucks.

We're at least to 1974-75? What is he talking about? U.S. real per capita GDP 35 years ago was approximately 50% lower than it is today; see first figure here.

Oh, wait a second...I think he was referring to GE's stock price.

But you see, this is not Immelt's fault. Nosiree. Jack Welch (legendary former CEO of GE 1981-2001) never experienced anything like this. Things are "different" this time around. In particular, there appears to be a shortage of "liquidity;" or a "credit crunch." Nope...I can't recall people ever talking about a phenomenon like this before during an economic downturn. This is why the government's role in this cycle is so gosh-darned important.

And just what, pray tell, might that role be? Well...you know...the government should do something...and it should do it right away...anything really big...anything, I presume, to legitimize the view that things are really different this time around; and that poor share price performance really has nothing to do with poor executive decisions.

Monday, February 2, 2009

How can one not love or hate Paul Krugman? (There appears to be no middle ground with this guy). He must have been an imp as a child; no doubt a terror to his parents and his petrified teachers. One cannot help but admire his academic contributions (primarily in international trade, for which he recently won a Nobel prize). He is courageous and opinionated; he is fun to read.

His impishness appears to have persisted well beyond middle age. On his personal webpage, he writes "With any luck, you will find many of these pieces extremely annoying." I think that he underestimates his own abilities in this regard; I am sure that luck has nothing to do with it at all.

Speaking of imps, I found it amusing to see that Robert Barro is a recent addition Krugman's Bonehead List. I am not in a position to evaluate Barro's government multiplier analysis or Krugman's critique of it. But I would like to comment on Krugman's update concerning Barro's interpretation of Keynes' economics. The quote from Barro is this:

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.

In reply to this, Krugman writes:

Is it too much to ask that someone criticizing Keynes actually, you know, read Keynes—at least enough to know that he devoted a whole chapter to explaining why a fall in wages would not expand employment?

I can hardly believe what I am about to say here, but...Krugman is absolutely correct; and Barro is being a bonehead on this matter. In support of Krugman, let me cite a relevant passage from Keynes' General Theory.

In this summary, we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money wages are liable to change. (Chapter 3, Part II)

Indeed, Keynes goes on to suggest in a later chapter that sticky wages were likely a good thing; and that flexible wages would serve to reinforce his general theory. The basic idea (as far as I understand it) is that falling wages would serve primarily to lower "effective demand;" leading to a further contraction in output and employment. It seems clear enough that Keynes had in mind some notion of "coordination failure;" i.e.,

Indeed it (the economy) seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. (Chapter 8, Part III).

Contrary to what some may believe, this type of outcome can be shown to be a theoretical possibility in suitably modified (and non-crazy) versions of otherwise standard neoclassical macro models (with fully flexible wages).

And so, Barro did indeed make a boneheaded remark. But to what might we attribute his error to? There is little doubt that this common boo-boo is the product of Hicks' interpretation of Keynes' theory; which relied heavily on the simplification of sticky wages alluded to above. Generations of economists were subsequently trained to believe that sticky wages were essential to Keynes' theory. The legacy of this "bastard Keynesianism" (Joan Robinson's colorful adjective) lives on today in the form of "New Keynesian" economics.

To see how this misperception lives on today, consider the following quotes from a graduate level macro course taught not too long ago at one of the world's best economics departments.

To make the transition (from neoclassical to Keynesian theory) we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline...

Finally, sticky prices play a crucial role in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory.

The lecture notes in question are available here. Who was the bonehead who made these remarks? Hint: His initials are not RB.

In my previous post, I made note of Paul Krugman's statement that "Everyone's looking back to the 1930s for policy guidance-and that's a good thing."

I think what he likely meant by this is that it is a good thing that everyone appears to acknowledge the self-evident fact of how FDR's New Deal policies lifted an unwilling American private sector out of what would otherwise have been a state of permanent stagnation; and how current policy should be designed with the knowledge of this experience firmly engrained in our minds.

It is certainly true that many people are looking back to the 1930s for current-day parallels. But obviously, not everyone shares Krugman's religion on this matter. Consider, for example, this recent piece by Professor Hal Cole (University of Pennsylvania) and Lee Ohanian (UCLA) in the Wall Street Journal:

Here we go again. Economic growth is slowing. Stock markets have plunged. Banks are failing. Perennial doomsayers are basking in a glow of perverted pleasure. A plethora of pundits are earnestly explaining the dire need for "stimulative" government spending measures to reverse the course of what will otherwise be a prolonged depression. In short, par for the course.

Well, perhaps not quite par. This time around, many governments appear to be taking seriously the notion that a massive government "electric shock therapy" is needed. Things certainly do seem gloomy out there. Is there any merit in the view that a massive government fiscal action can rescue the day? Apparently, there must be. Why would all these learned people be advocating a policy prescription that is not solidly backed by economic theory and the historical evidence?

To learn more about this view and what underlies it, I decided to visit the arch-liberal Professor Krugman. He begins a recent article by stating that

Everyone’s looking back to the 1930s for policy guidance—and that’s a good thing. But we don’t have to go back that far to see how fiscal policy works in a liquidity trap; Japan was there only a little while ago.

Japan? Well, this sounds promising. What does he have in mind exactly? Evidently, it is the evidence provided in Adam Posen's new book, Chapter 2, entitled Fiscal Policy Works When it is Tried.

Posen argues that, contrary to common perception, Japanese fiscal policy during the 1990s was not really expansionary. On pg. 49 he highlights an exception to this case; a brief period in September 1995. He interprets the corresponding increase in GDP in late 1995 and early 1996 as being attributable to the September stimulus package. This is his evidence that fiscal policy works when it is tried.

Well, maybe he's right. Or maybe not. Quite frankly, I doubt that anyone really knows. In any case, I thought it would be interesting to see how this hypothesis might square up with another look at the data. For this purpose, I chose to consult the Penn World Tables; an international data set frequently used to make international comparisons.

In what follows, I compare Japan to the US. Annual data is available for the time period 1950-2004. I take a look first at levels of real per capita income (GDP) across these two countries. The data look a lot like what one would expect. Relatively stable growth in the U.S., interrupted by the occasional recession. The post-war Japanese growth "miracle," interupted briefly in the 1970s, the late 1980s boom followed by the "lost decade" of economic stagnation.

Next, let's take a look at the available measure of government spending (government purchases; which excludes that sizable chunk of government spending in the form of entitlements). The data reveal a general upward trend, as one would expect in growing economies. Significant bumps in US government spending occur during the Korean war, the peak of the Vietnam war, and in the late 1980s. The growth in government spending in Japan appears more stable and rapid. Note that the 1995 stimulus bill (and subsequent contraction) highlighted by Posen shows up as a relatively minor blip on this chart. Moreover, the pattern appears to have been sharply reversed in the late 1990s and into the 2000s.

A better measure of the "size" of government is to compare it to the "size" of an economy; say, as measured by its GDP. The next figure plots the ratio of government purchases to GDP. By this measure, the relative size of the U.S. government has been in secular decline since the Korean war. There is an even sharper secular decline in the relative size of the Japanese government in the early part of the sample. This latter trend appears to have ended by 1970; and has shown signs of accelerating upward since 1990. On the basis of this data, I think that one might be forgiven for adopting the "mistaken" impression that Japanese fiscal policy has been largely expansionary since 1990.

The last figure I present considers the relative magnitudes of GDP across Japan and the U.S.; as well as the relative magnitudes of the government spending (purchases) share (GPS) across these two economies.

The blue line plots relative income (real per capita GDP). That is, in 1950, real per capita income in Japan was roughly 20% of that of the U.S. By 1970, it was roughly 70%; and by 1991, it was roughly 85%. By any measure, this constitutes a remarkable economic achievement. And this must especially be the case when one considers the devastated state of the Japanese economy at the end of WW2.

The question I want to ask here relates to the behavior of the relative size of government spending over this episode; this is plotted by the red line in the figure. The downward plunge in the early part of the sample reveals that Japanese government spending (as a fraction of GDP) declined rapidly relative to its U.S. counterpart. The upward rise during the latter part of the sample reveals that Japanese government spending (as a fraction of GDP) increased rapidly relative to its U.S. counterpart. The most interesting thing to note is that the blue and red lines are virtual mirror images of each other.

Of course, there are several ways in which the patterns displayed in this data might be explained or interpreted. I am especially eager to learn how this evidence might be construed as supporting the notion that fiscal policy "works" and how this lesson from Japan might be fruitfully employed to cure the current economic crisis.

Subscribe To

Favorite Quotations

"Believe those who are seeking the truth. Doubt those who find it." Andre Gide

The Democrats are the party that says government will make you smarter, taller, richer, and remove the crabgrass on your lawn. The Republicans are the party that says government doesn't work and then they get elected and prove it (P.J. O'Rourke)

But to manipulate men, to propel them toward goals which you – the social reformers – see, but they may not, is to deny their human essence, to treat them as objects without wills of their own, and therefore to degrade them (Isaiah Berlin)

I believe that sex is one of the most natural, wholesome things that money can buy (Steve Martin)

Nothing so needs reforming like other people's habits (Samuel Clemens)